Distribution Waterfall
The order in which sale or liquidation proceeds are paid out to creditors, preferred stockholders, and common stockholders based on liquidation preferences and conversion decisions.
Definition
A distribution waterfall is the modeled sequence in which proceeds from a sale, merger, or liquidation of a company are allocated among stakeholders. Secured and unsecured creditors are paid first, followed by preferred stockholders in order of seniority up to their liquidation preference (as set out in the certificate of incorporation), with any remaining proceeds distributed to common stockholders (and to preferred stockholders that convert to common if participation or conversion produces a larger payout). Each preferred series' rank (senior, pari passu, or subordinate to other series) and preference multiple (1x, 1.5x, 2x) determine where it sits in the waterfall, and participating preferred stock can receive both its preference and a pro-rata share of the remaining common proceeds.What this means in practice
MedTech exits often occur through acquisition by a strategic acquirer shortly after a pivotal trial readout or regulatory clearance, sometimes at valuations only modestly above total invested capital. Because MedTech companies frequently raise several rounds of preferred stock across a long development timeline, the waterfall can consume most or all of the exit proceeds through liquidation preferences before common stockholders (including founders and employees) receive a meaningful payout, making waterfall modeling essential before evaluating any acquisition offer.Examples
- A company raised $5,000,000 in Series A (1x non-participating preference) and $15,000,000 in Series B (1x non-participating preference), both senior to Series A. On a $22,000,000 sale: Series B takes its $15,000,000 preference first, Series A takes its $5,000,000 preference next, leaving $2,000,000 for common stockholders, who may instead choose to have Series A or B convert to common if that produces a larger payout under the as-converted math.
- If the same Series B were participating preferred with no cap, Series B would take its $15,000,000 preference and then also share pro-rata in the remaining $2,000,000 alongside common and Series A (if Series A converts), further reducing what founders and employees receive relative to the non-participating scenario.
- •Assuming liquidation preference stacks are always paid pari passu; many term sheets set explicit seniority (later rounds senior to earlier rounds) that changes payout order.
- •Overlooking participation rights, which let certain preferred holders 'double dip' by taking their preference and then sharing in the residual common pool.
- •Failing to model the waterfall before signing a term sheet for a new round, which can retroactively push earlier common stockholders and option holders far down the payout order in a modest exit.
Frequently asked questions
Related terms
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· Hand-selected related conceptsLedger of all securities issued by a company and who owns them.
The base class of equity typically held by founders and employees, standing last in the distribution waterfall behind creditors and preferred stockholders.
Right of preferred shareholders to be paid before common in an exit.
Class of equity with rights superior to common stock.
More in Investment & Finance
· Same categoryAn independent fair-market-value appraisal of common stock used to set tax-compliant strike prices for employee stock options.
Adjustment that protects investors if the company raises a future round at a lower price.
The governing body elected by stockholders that oversees management, approves major corporate actions, and typically includes investor-designated seats after venture financing.
Interim financing between priced rounds, usually convertible.
Where this term appears across MedTech Terms.
Sources
3 sourcesEvery citation below opens the original document. Each is graded against our source-tier hierarchy so you can see what rests on binding law versus commentary.
- 1Cornell LII: Liquidation PreferenceTier 1 UncheckedCornell Law LIIlaw.cornell.edu
- 2SEC Investor.gov: Preferred StockTier 2 UncheckedSEC Investor.govinvestor.gov
- 3NVCA Model Certificate of IncorporationTier 4 VerifiedNVCAnvca.org
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